Emerging-Market Gains Replace US Housing, Mortgage Woes

Source : The Business Times, October 4, 2007

Investors flock to Asia and developing countries in wake of Fed's recent rate cut

(LONDON) The bursting of US housing and mortgage market bubbles has suddenly been replaced by emerging markets inflating, and world equities have got pumped up into the bargain.

With the herd mentality of global investors ever sharper, the US Federal Reserve's decision two weeks ago to combat a US credit market seizure with lower interest rate has stampeded investors to Asia, Latin America and elsewhere in the developing world.

Investment flows to emerging equity funds hit an 85-week high of US$5.53 billion last week, with redemptions from developed market funds providing most of this cash, according to EPFR Global, which tracks funds with US$10 trillion in assets globally.

Non-Japan Asia received 53 per cent of the total.

And the price action echoes that. MSCI's index of emerging market equities has accelerated more than 13 per cent to record highs since the Fed cut on Sept 18 and has clocked up a whopping 36 per cent gain so far in 2007. China's main bourse has more than doubled this year.

Brazil is up some 60 per cent.

'I worry about emerging markets looking into next year. They are the next bubble in this environment - especially if the Fed decides to take back its insurance rate cut,' said Phil Suttle, director of Global Macroeconomic Analysis at the Washington-based Institute for International Finance.

Mr Suttle said the Fed ease replayed a now almost routine response to Western banking stress and looked set to perpetuate a cycle of market bubbles that moved from Asia in the mid-1990s to technology at the end of the decade and housing post-2001.

But emerging markets are particularly prone to bubble behaviour because they are small compared with the deep and mostly liquid equity and bond markets of the world's major economies.

Analysts at Merrill Lynch estimate that equity markets in Brazil, Russia, India and China represent only 4 per cent of world market capitalisation compared with 44 per cent for the US equity market alone.

'The short and intermediate risks to emerging market equity prices remain skewed to the upside and we continue to think that an asset bubble seems likely, led by BRIC markets,' Merrill told clients this week.

The fear is that when money starts to leak from developed to developing markets it supercharges already-elevated assets and stokes inflationary and systemic problems down the road.

'Global emerging markets are still small so asset managers' switch to emerging markets has a disproportionate impact,' said Richard Batty, investment director at Standard Life Investments.

'And there is still a lot of liquidity out there,' said Mr Batty, adding up to 65-70 per cent of leveraged corporate bond investor holdings are in cash right now and need to reinvest.

But the unleashing of a new wave of global liquidity comes just at a time when many policy-makers and central bankers are urging caution about inflation and commodity-price pressures.

Managing those pressures will now be trickier as money sloshes around the system and surfaces in unintended places.

Fundamental factors driving funds into emerging markets are well documented.

Economies there continue to boom. The International Monetary Fund (IMF) expects developing country growth, at 7.5 per cent this year, to be three times that of the developed world.

This boom, in turn, is fuelling world commodity prices and dropping massive windfalls in commodity-rich emerging nations.

But, perhaps most powerfully, the US dollar is falling sharply on the back of a US economy being weakened further by housing and credit problems. The Fed cut heaped on the pressure.

This dollar weakness has tempted more US funds offshore and flooded the coffers of emerging market central banks intent on preventing a greenback slide undermining their exports.

'Mutual funds are switching away from the US to emerging markets,' said Mr Batty, adding some of the US$700 billion of US equity which was dumped last year leaked straight to emerging markets.

But why in the face of recession fears and a falling currency has Wall Street too powered to a record high on Monday? Two big reasons are related to emerging markets too.

The first is that rising hard currency reserves in emerging markets - US$4.3 trillion at the IMF's last count - are partly being channelled into so-called sovereign wealth funds and are expected to be reinvested over time in world markets such as US and European equities among others.

Investment banks estimate the total size of these sovereign funds could climb as high as US$12 trillion by 2015.

And another reason for US and European equities being drawn into the slipstream is transnational firms there are increasingly dependant on earnings growth from overseas. -- Reuters